Select Committee on Treasury Minutes of Evidence


Memorandum submitted by the Financial Services Authority

INTRODUCTION

  1.  This memorandum is submitted in response to the Committee's request of 22 March. The memorandum covers:

    —  who does what in the financial regulation of companies and in the oversight of auditors;

    —  the role of the FSA in these areas;

    —  the action the FSA has taken since the collapse of Enron; and

    —  FSA work already underway in these areas.

BACKGROUND—FINANCIAL REGULATION AND OVERSIGHT OF AUDITORS

  2.  The financial regulation of public limited companies and the oversight of auditors in the UK involves a number of organisations, primarily the DTI and the Accountancy Foundation. Their responsibilities are outlined briefly below. The FSA's specific role is covered in sections C, D and E.

  3.  The DTI is responsible for the relevant legislation—the Companies Acts—which cover how companies govern themselves and how they present their financial position. In relation to auditors, the Acts also, for example, regulate their qualifications and set out their rights and duties. In the light of the DTI's responsibility in this area, Patricia Hewitt announced on 27 February that a joint DTI/HMT group would be set up to co-ordinate a response to the issues raised by the collapse of Enron. This group includes representatives from the FSA (Michael Foot, MD, Deposit Takers and Markets Directorate), the Accounting Standards Board and the Accountancy Foundation. It is jointly chaired by Melanie Johnson MP and Ruth Kelly MP. The Group had its first meeting on 11 April. The Government has said that if there is a need for specific legislative change in auditor regulation or other aspects of company law, it could take action either under existing powers or as part of the proposed Companies Bill.

  4.  Although there are some statutory controls over auditing through the Companies Acts, the arrangements for oversight of accounting and auditing in the UK are largely self-regulatory. These are explained below.

  5.  The Financial Reporting Council (FRC) oversees the process of setting and enforcing accounting standards. It is an independent body jointly funded by the profession, the financial community (the FSA collects a levy on listed companies for this purpose) and the DTI. The FSA is represented on the FRC by Michael Foot. It has two operational subsidiary bodies:

    —  The Accounting Standards Board (ASB) is responsible for setting and keeping under review UK accounting standards and can issue standards on its own authority. The members of the Board (including a full-time Chairman and Technical Director) are appointed by a Sub-Committee of the FRC; and

    —  The Financial Reporting Review Panel (FRRP) investigates apparent departures by companies from UK Generally Accepted Accounting Practice (GAAP) which are brought to its attention. It can require companies to rectify identified deficiencies and has the power to seek a court order to enforce this if necessary. Its decisions are published, with the resulting prospect of unfavourable publicity for both the company concerned and its auditors. The members or the FRRP are also appointed by an FRC Sub-Committee.

  6.  The regulation of the profession itself is now established along similar lines. A lead body, the Accountancy Foundation, has been established with members nominated by key bodies specified in its constitution, including the Bank of England but not the FSA. The Foundation appoints the members of four Boards and acts as a channel for financing them. Three operational Boards are responsible, respectively, for auditing standards, ethical standards and public interest investigations/disciplinary cases. A Review Board is responsible for oversight of the system as a whole, including those activities for which the professional bodies are responsible.

  7.  Day-to-day regulation of audit firms is undertaken by the professional bodies, principally the Institutes of Chartered Accountants as "recognised supervisory bodies" under the Companies Act 1989. The professional bodies report annually to the DTI on their activities in regulating audit firms and promoting the raising of standards. The DTI makes these reports publicly available. The Review Board has said that it intends to undertake a review of the current arrangements for the registration and monitoring of audit firms as one of its early major projects.

  8.  The DTI is also putting in place a new whistleblowing regime under the Public Interest Disclosure Act (the Enron scandal was initially exposed by a whistleblower). The regime is designed to enable workers to make disclosures, which are in the public interest, by giving them protection from victimisation by their employer. Under the Act the FSA is a "prescribed body" which means workers can blow the whistle to us if they feel it is necessary. This will provide a further useful tool in identifying problems in firms, for example of the kind that came to light in the Enron case.

  9.  At the international level responsibility for setting and keeping under review international accounting standards rests with the International Accounting Standards Board (IASB). It is an independent privately funded body established in April 2001 and based in London. It was previously known as the International Accounting Standards Committee. Howard Davies sat on its Nominating Committee, which appointed the first Trustees for the IASB. The IASB aims to develop a single set of high quality, understandable and enforceable global accounting standards. It co-operates with national standard-setters to achieve convergence in accounting standards internationally.

  10.  The Securities and Exchange Commission (SEC) is the lead regulator in the US in this area. Following the Enron failure the SEC said that it plans a number of initiatives.

  Possible initiatives in the UK will need to be considered in the light of likely changes being made in the US. The SEC initiatives include:

    —  reform of management disclosure so that firms disclose, for example, off-balance sheet financing arrangements;

    —  review of the corporate disclosure regime which could lead to shorter filing deadlines for annual and interim reports;

    —  in relation to corporate governance, consideration of how to improve sanctions available against directors who violate their duties to public shareholders; and

    —  proposals for a new organisation to oversee the accountancy profession and move away from the current system of self-regulation.

C.  THE ROLE OF THE FSA

  11.  The FSA regulates and sets standards for firms doing financial business in the UK. All firms and individuals enter the regulatory environment through an authorisation or approval process. Our assessment at entry aims to allow only those firms and individuals satisfying the necessary criteria (including honesty, competence and financial soundness—the "fit and proper" test) to engage in regulated activity. The FSA's responsibilities and locus in this area are outlined below.

  12.  As the UK Listing Authority, the FSA has responsibility for regulating issuers listed securities. The FSA's listing rules apply to all firms listed on the Stock Exchange and impose ongoing obligations on companies, such as providing a regular flow of relevant information to the market. New applicants to the market are scrutinised to ascertain their eligibility to listing. Applicants must take all reasonable steps to ensure their auditors are independent of the applicant, and obtain confirmation that the auditors comply with the guidelines on independence issued by their national accountancy bodies. We will be launching a review of the listing regime in the next two months.

  13.  The FSA also has an interest in auditing/accounting developments as a prudential regulator. In a global economy companies operate across borders and in many countries. It is important therefore that we have standards in, for example, financial reporting, which are consistent and comparable across the major markets. The FSA, therefore, plays a full part in the work of banking (the Basel Committee), insurance (the International Association of Insurance Supervisors) and securities regulators (International Organisation of Securities Commission, IOSCO) in relation to developing standards. Our objective here is to achieve the long-term goal of a single set of consistently applied and enforced International Accounting Standards (IASs) that are audited in accordance with a single set of International Standards on Auditing (ISAs). The FSA has no formal powers in this area and can only seek to influence organisations which are in a position to take action.

  14.  Some progress is being made in these international discussions. For example, IOSCO, which sets common standards for the regulation of investment business, has formally endorsed the use of IASs in cross-border listings. The EU has agreed to require all EU listed companies to use IASs for their consolidated accounts from 2005. A regulation to this effect is expected to be adopted shortly (it was recently approved by the European Parliament) and an EU Recommendation on auditor independence will be adopted by the end of April. IOSCO is now reviewing International Standards on Auditing with a view to being able to endorse them as well in due course. However, there is still much to do in terms of establishing closer links with the US to achieve greater global convergence of accounting practice and to set in place mechanisms that will lead to consistent application and enforcement of international standards.

  15.  It is vital for the FSA that accounting standards and auditor independence standards are effective both domestically and internationally. We rely on the work of auditors in our supervision of regulated firms, both in relation to the audited statutory accounts and regulatory returns on which auditors are required to report. This is way we are active in developing standards. As far as the auditors of regulated firms are concerned, under the Financial Services and Markets Act (FSMA), we have the power to disqualify an auditor firm from acting as an auditor if it appears to us that the firm has failed to comply with a duty imposed on it under the Act. The auditors of regulated firms have a duty to make a report to the FSA in certain circumstances (eg the auditor reasonably believes that the firm is not, may not be or may cease to be a going concern) and a clear failure to comply with this duty would be grounds for the FSA to disqualify the audit firm.

D.  ACTION TAKEN BY THE FSA SINCE THE COLLAPSE OF ENRON

  16.  The FSA has taken a number of steps since the collapse of Enron (the Committee will be aware of Howard Davies' speech to the World Economic Forum earlier this year which is attached):

    —  the FSA's immediate regulatory response focused on:

handling the problems presented by the three legal entities owned by Enron that were authorised by the FSA. These were closed or sold without loss to counterparties;

monitoring actively the prudential and confidence risks arising in the markets in which Enron traded in the UK and from UK entities' world-wide exposure to Enron;

    —  the FSA conducted its own analysis of issues in the aftermath of the Enron collapse. This highlighted a number of issues:

the FSA currently accepts use of US GAAP (especially in respect of Special Purpose Vehicles (SPVs)) by the US and third country banks authorised in the UK. We are concerned to establish what changes are proposed in the US to address perceived weaknesses in SPVs. The FSA would be interested to be involved in any desired changes in relevant UK accounting standards initiated by the ASB. We will also continue to keep under close scrutiny the most appropriate regulatory treatment of the complex financial instruments that were at the heart of Enron's problems. With the rapid evolution of such instruments, regulators and accountants need to be constantly on the alert to ensure that their approaches accurately reflect the underlying economic reality of the instruments themselves;

conflicts of interest in the work of investment analysts employed by the large investment banks has been of concern to the FSA for some time. It has been given renewed impetus by suggestions of partiality by analysts employed by Enron's investment bank advisers and complaints to date have focussed on the US. The FSA has started a project to review our current conduct of business requirements that already exist in this area. Any proposed changes in FSA rules or guidance would require public consultation;

    —  the FSA reviewed its existing policy on oversight of non-financial groups with financial services subsidiaries (Enron was such a group) and concluded that existing policy was sufficient (the policy seeks to ring-fence financial firms from their non-financial parents);

    —  we will review the present capital requirements for the legal entities operating in the financial energy markets and look further at the implications of liquidity or default shocks to these markets in the light of our experience with Enron.

  17.  The Enron collapse has also highlighted issues or risk management and risk transfer. It is apparent that not all of the major banks fully understood the total size of their exposure to Enron and we will be reviewing with them how this issue can be better managed. Our concerns about the risks of certain forms of credit transfer (notably between banks and insurance companies) have been heightened. We will shortly be publishing work on the nature and extent of cross-sector risk transfer, as a contribution to the continuing debate among firms and regulators about the issues involved.

E.  WORK ALREADY UNDER WAY

  18.  We are continuing work on the review of the listing regime referred to above. The review was part of our work plan before the collapse of Enron; it was one of the conditions on which we took over responsibility for the listing rules from the Stock Exchange in May 2000.

  19.  The FSA has already made clear that it will consider issues of auditor independence as part of the review. The FSA's proposals, however, would only apply to auditors of listed companies. Any changes to our requirements would be developed following the disciplines required by the Financial Services and Markets Act, including public consultation and cost-benefit analysis. The issues are likely to be examined include:

    —  rotation of auditors at a defined period. There is currently no requirement for rotation of audit firms, although the lead partner on an audit must rotate at least every seven years;

    —  regular retendering by companies of contracts for audit work. This would not rule out the possibility that the current auditor would be re-appointed. However, it would break the normal assumption that auditors are re-appointed every year;

    —  the split between audit and consultancy work. This would consider limits or restrictions on the amount or type of non-audit work which an audit firm can do for an audit client. The FSA will also keep in touch with the work of the Ethics Standards Board (part of the Accountancy Foundation) in this area and, in particular, a consultation exercise covering these and other issues which it is planning.

19 April 2002


 
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